Transferring a business insurance policy may have a tax impact

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Planning ahead helps you purchase a life insurance policy with a business with less tax risk.

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You’ve started a business, you’ve staked everything in it for decades, and now you’re ready to sell your business shares and move on.

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But, when you sell those stocks, you still need to make sure you come away with a very valuable asset – the “key person” insurance policy that the company has taken out for you in the event of death.

The majority of baby boom-era business owners in Canada are at a crossroads, with 70 percent saying they plan to sell or transfer ownership to the next generation over the course of the next few years, according to a PWC report.

If you are one of those founders and want to keep this insurance policy, you should be aware that transferring it is feasible, but may come with a tax impact.

Why companies insure their own staff

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Companies that have borrowed money are often required by the lender to have insurance policies for their key people.

There are three main reasons a private company insures the lives of its key people, says Kevin Wark, tax advisor for the Conference for Advanced Life Underwriting and managing partner at Integrated Estate Solutions in Toronto.

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First, the business borrowed the money and the lender asked for collateral in the form of life insurance on the owner / manager. This insurance becomes a guarantee to ensure that the company’s loans can be repaid in the event of the death of a key person.

“The police protect the financial institution as well as the families of key individuals because they will not be burdened with debts incurred by the company,” says Wark.

Second, two or more shareholders have a legal agreement to buy each other’s shares. It can be difficult to raise the cash to buy them if an owner dies. The company therefore takes out insurance that will finance the cost of acquiring the shares.

Third, if it is a family business that will be passed on to the children, the owner may want the insurance money to go to the estate to pay taxes on the growth in the value of the company’s shares. which the children will inherit.

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Why a professional seller would want to keep insurance

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When a business pays the premiums on a founder’s life insurance policy for years, it can generate significant cash value for an owner who sells his company’s stock.

You probably started your business when you were young and bought a permanent insurance policy to make sure the coverage would last the entire time you owned your business.

Permanent insurance products also have level premiums and can eventually be fully funded. So when you decide to sell, the company’s policy on your life may have considerable cash value accumulated in the savings component of the policy.

“The company has paid the premiums for a number of years, which creates value in the policy,” Wark explains.

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Now all you have to do is take the insurance out of the business and put it in a structure that pays it to your estate or designated beneficiaries.

Beware of tax consequences

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A business insurance policy can be particularly useful for a former business owner who cannot replace that policy for medical reasons. But transferring the policy to personal use may have tax consequences.

You will need to move the policy in a tax efficient manner, Wark says. There are two main issues.

First, the transfer of the policy is treated as a sale and the rules of the tax law specify the value the policy has earned since it was purchased.

For shareholder transfers, the tax law calculates the proceeds as the greater of three amounts: the cash surrender value of the policy, the cost of the policy, and whether cash or other consideration has been paid for the policy. .

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Wark says there could also be a taxable gain for the company. And if you don’t pay for the policy when you sell your shares and the policy is transferred, the Canada Revenue Agency (CRA) could say that you received a taxable benefit equal to the fair value of the policy.

“This is a transfer from an in-force policy, and the fair market value of that policy could be high,” Wark says.

This can be especially true for someone who is older or in poor health, who would have difficulty obtaining a replacement policy.

Three scenarios

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Setting up a holding company can help you transfer a business insurance policy with less tax impact.

The worst-case scenario of buying a policy from a business is for them to transfer it to you without any payment being made. This could trigger a tax return within the company because the CRA sees it as a police sale. In addition, there is a shareholder benefit equal to the fair market value of this insurance policy.

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“We see situations where the policies are transferred because the person has not received advice,” says Wark. “Suddenly they have to face these very negative tax consequences. “

A better solution is for the company to pay you the policy as a dividend, but at full value. So if it was a million dollar policy with a cash surrender value of $ 100,000, says Wark, you would present it to an appraiser and he would say it’s worth $ 200,000.

“We convert that to a dividend of $ 200,000 and transfer the policy into payment,” he says. “That way you get the dividend tax credit and the total tax payable is lower.”

But the best way to transfer a policy is to do what is called a stock reordering. You create a holding company (which you own) and insert it between you and the operating company you sell.

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The operating company then pays the insurance policy as a dividend to the holding company.

“Typically, dividends paid between corporations and holding companies are tax-exempt,” Wark explains. “The policy therefore goes to the holding company, which the shareholder continues to own after selling the operating company.”

One concern remains: a provision in the tax law could convert the dividend into a capital gain in certain circumstances.

“You can deal with it by having a holding company in place [when you start your business] so he has the insurance, ”says Wark. “The holding company or the operating company can be a beneficiary. And because the policy is not transferred out of the holding company, negative tax consequences can be avoided. “

In other words, plan ahead.

This article provides information only and should not be construed as advice. It is provided without warranty of any kind.

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In-depth reporting on The Logic’s innovation economy, presented in partnership with the Financial Post.

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